Tim Harford wrote an interesting piece for BBC this week on the line between gambling and insurance. He also mentioned derivatives which piqued our interest.
In the article, Harford recounts that the Lloyds insurance market originated as a group of people taking a bet on topical events and evolved into a bigger group of people taking lots of bets on many different things – which ultimately became what we now call insurance.
We have alluded to this before by saying that something that seems like a gamble (a bet on red on a roulette wheel, let’s say) may actually constitute a reduction in risk (if, for example, you have already placed a bet on black). The same is true of derivatives usage – they may look like a leveraged bet in isolation (on interest rates or equity market falls for example) but pension schemes see value in them because they already have an offsetting risk in place (liabilities and equity holdings).
Harford’s article provides crop insurance as an example. Crop insurance is not dissimilar to a bet on the weather. For instance, it may be a bet that there will be little or no rainfall in any given year. However, African farmers have an offsetting risk that, in the event of drought, they will lose their crops. Consequentially, taking a bet on dry weather actually gives those farmers confidence that, should the weather be against them, they will be compensated for an otherwise poor year. In fact, Harford suggests that studies have shown that farmers who buy crop insurance actually increase their productivity as a result of this additional confidence they’ve gained by having the security in place. There is an interesting TED talk from Rose Goslinga on this subject here.
This method of insurance is not hugely dissimilar to the function of brakes in cars. How fast would you be prepared to drive if your car had its brakes removed? I think most of us would drive significantly slower.
The interesting point here is that something that costs us money (insurance) or that is designed to slow us down (brakes) can actually improve our performance. In a financial context, the point is that risk management tools shouldn’t be seen as something which only acts as a drag on return.
The confidence provided by having those tools in place may give you the confidence to invest and earn the return you need.
Tim Harford links to derivatives as a way of gambling on financial outcomes. Clearly this is true for some people. However, for pension schemes, derivatives are used as a risk management tool that offsets another risk. The idea being that this not only provides protection but also provides confidence to invest.
Over the next few months we intend to test this idea with pension scheme representatives by giving them an opportunity to drive around our ‘circuit’ both with, and without, brakes. We will report back with our findings.
To view more insight from River and Mercantile's derivatives team, see here.